Meaning of foreign exchange rate


foreign exchange rate
meaning of foreign exchange rate


The foreign exchange rate or exchange rate is the rate at which one currency is exchange for another currency. This is the price of one currency in terms of another currency. It is customary to define the exchange rate as the price of one unit of the foreign currency in terms of the local or domestic currency.

The exchange rate between the American dollar and the British ponds refers to the number of American dollars needed to purchase or buy British ponds. Thus this exchange rate between the dollars and pounds from the united states point of view is shown and express as 2.5$ is equals 1 pound.  The British will show and express it as the amount of pounds required getting one dollar, and the above exchange rate would be expressed as 0.40 pounds equals 1 dollar

The exchange rate of 2.50 dollars equals 1 pound or 0.40 pound equals 1 dollar will be maintained in the world foreign exchange market by arbitrage. Arbitrage in this case refers to the buying of a foreign currency in a market where its price is low and then sells it in some other countries market where the price is higher. The effect of this practice called arbitrage is to remove differences in the foreign exchange rate of currencies so that there is a single exchange rate in the world foreign exchange market. If the exchange rate in the United Kingdom is 2.48 dollars in the exchange market and 2.50 dollars in the New York exchange rate market, foreign exchange speculators and observers also known as arbitrageurs, will purchase pounds in United Kingdom and in turn sell them in New York, thereby making a profit of 2 cent on each pound. As a result, the prices of pounds in terms of dollar rises in United Kingdom market and fall in the New York market.

Ultimately, it will equal in both the markets and arbitrage comes to an end. If the exchange rate between the American dollar and the British pounds to 2.60 dollars equal 1 pound through the period of time, the dollar is said to depreciate with respect to the pounds, because now more dollars are needed to buy one pound, When the rate of exchange between the dollar and the pound falls to 2.40 dollars are required to buy on pound. If the value of the dollar against the, pound in the same thing as the appreciation of the pound against the dollar, and vice versa


Determination of equilibrium in foreign exchange rate


The exchange rate in a free market is determined by the demand for and the supply of foreign exchange. The equilibrium exchange rate is the rate at which the demand for foreign exchange equals supply of foreign exchange. In other words, it is the rate which clears the market for foreign exchange. In relation to the meaning of foreign exchange rate, ranger nurkse an economic expert defines the equilibrium exchange rate as “that rate which over a certain period of time, keeps the balance of payment in equilibrium”.

There are two ways of determining the equilibrium exchange rate. The rate of exchange between the dollar and the pounds can be determined either by the demand and supply of dollars with the price of dollar in pounds, or by the demand and supply of pounds with the prices of pounds in dollars. Whatever method that is adopted, it will yield the same outcome. The analysis that follows is based on the dollar price in terms of the pounds.


The demand for exchange rate:


The demand for foreign exchange is a derived demand from pounds. It arises from import of British goods and services into the United States and from capital movement from the united state to Britain. Infarct, the demand for pounds implies a supply of dollars. When the united state businessmen buy British goods and services and make capital transfers to Britain, they create demand for British pounds in exchange for united state dollars because they cannot make payment to Britain in their currency, the united state dollars.

The demand for foreign exchange curve for pounds demand is downward sloping from left to right. This implies that the lower the exchange rate on pounds, the greater will be the quantity of pounds demanded in the foreign exchange (united state) market, and vice versa. This is because a lower exchange rate on pounds makes the British export of goods and services cheaper in terms of dollars. The opposite will happen if the exchange rate on pounds is higher. This will make the British goods services dearer in terms of dollars, and the demand for pounds will fall in the foreign exchange (united state) market.

But the shape of the demand curve for foreign exchange will depend on the elasticity of demands for imports. If a nation imports important goods and raw materials, we may expect the foreign exchange elasticity of demand for imports to be low and the quantity imported to be insensitive to price changes. If, on the other hand, the nation imported luxurious goods and such goods which the suitable substitutes exist, demand elasticity’s for imports might be high. If the country has many well developed import competing industries, the elasticity of demand for imports may not be very high In the long run. However it is much more probable that the production method will alter according to the price changes, and the demand for imports, therefore, will be more elastic.


The supply of exchange rate:


The supply of foreign exchange in our case is the supply of ponds. It arises from the united state export of goods and services and from capital movement from the United States to Britain. Pounds are offered in exchange for dollars because Britain holders of pounds wish to make payments in dollars. Thus the supply of foreign exchange reflects the quantities of pounds that would be supplied in the foreign exchange market at various dollars pin the rises of pounds.

The supply curve for pounds ss in an upward sloping curve, it is a positive functions of the exchange rate on pounds. As the exchange rate on pounds increases, the greater is the quantity of pounds supplied in the foreign exchange market. This is because with increase in the dollar price of pounds (lower pounds price of dollar), united state goods, services and capital funds become better bargains to holders of pounds. Therefore the holder of pounds will offer larger quantities of pounds with the increase exchange rate.

But the shape of supply curve of foreign exchange will be determined by the elasticity of the supply curve. As the value of the country’s own currency increase, import becomes relatively cheaper, and more imported. As more is imported, more of the home currency is supplied on the foreign exchange market, provided elasticity is greater than unity.

When imports become relatively cheap, new goods will start to be imported, and domestic import competing industry will be gradually eliminated by imports. These are two important reasons why we expect the supply of foreign exchange to be quite elastic. Further, the larger the time perspective we take into account, the more elastic will be the supply.

R2                  DB                        A   S


R                   G                 E               exchange rate (dollar price of pounds)

R1        S                                   H                         

O                                 Q pounds      D


Equilibrium exchange rate:


Given the demand and supply curve of foreign exchange, the equilibrium exchange rate determined where DD, the demand curve for pounds intersect SS, the supply curve of pounds. They cut each other at point E in the above figure. The equilibrium rate is OR and OQ of foreign exchange is demanded, supplied. At OR exchange rate the united state demand pounds equals the British supply of pounds, and the foreign exchange market is cleared. At any higher rate than this, the supply of pounds would be larger than the demand for pounds so that some people who wish to convert pounds into dollar will be unable to do so. The price of pounds will fall, fewer pounds will be supplied and more will be demanded. Ultimately, the equilibrium rate of exchange will be re established. 


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